What is an Inflation Swap?

An inflation swap is a contract used to transfer inflation risk from one party to another through an exchange of fixed cash flows. In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by the notional principal amount. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.

Understanding Inflation Swaps

The advantage of an inflation swap is that it provides an analyst a fairly accurate estimation of what the market considers to be the 'break-even' inflation rate. Conceptually, it is very similar to the way that a market sets the price for any commodity, namely the agreement between a buyer and a seller (between demand and supply), to transact at a specified rate. In this case, the specified rate is the expected rate of inflation.

Simply put, the two parties to the swap come to an agreement based on their respective takes on what the inflation rate is likely to be for the period of time in question. As with interest rate swaps, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged), but instead of hedging against or speculating on interest rate risk their focus is solely on the inflation rate.

Inflation swaps are used by financial professionals to mitigate (hedge) the risk of inflation and to use the price fluctuations to their advantage. Many types of institutions find inflation swaps to be valuable tools. Payers of inflation are typically institutions that receive inflation cash flows as their core line of business. A good example might be a utility company because its income is linked (either explicitly or implicitly) to inflation.

Key Takeaways

  • An inflation swap is a transaction where one party can transfer inflation risk to a counterparty in exchange for a fixed payment.
  • Inflation swap provides a fairly accurate estimation of what the market considers to be the 'break-even' inflation rate.
  • Inflation swaps are used by financial professionals to mitigate (hedge) the risk of inflation and to use the price fluctuations to their advantage.

How an Inflation Swap Works

One party to an inflation swap will receive a variable (floating) payment linked to an inflation rate and pay an amount based on a fixed rate of interest, while the other party will pay that inflation rate linked payment and receive the fixed interest rate payment. Notional amounts are used to calculate the payment streams. Zero coupon swaps are most common, where the cash flows are swapped only at maturity.

As with other swaps, an inflation swap initially values at par. As interest and inflation rates change, the value of the swap's outstanding floating payments will change to be either positive or negative. At predetermined times, the market value of the swap is calculated. A counterparty will post collateral to the other party and vice versa depending on the value of the swap.

An example of an inflation swap would be an investor purchasing commercial paper. At the same time, the investor enters into an inflation swap contract receiving a fixed rate and pays a floating rate linked to inflation. By entering into an inflation swap, the investor effectively turns the inflation component of the commercial paper from floating to fixed. The commercial paper gives the investor real LIBOR plus credit spread and a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.